The number is up for Wall Street
Larry Elliott
Monday July 1, 2002
The Guardian
George Bush is in trouble. WorldCom's collapse is one scandal too many. In the United States, it is being talked about as Wall Street's Watergate. It's that serious.
Despite his 70% approval ratings, President Bush knows that there are political and economic ramifications of the perception that corporate America is run by a bunch of greedy crooks, and that these same greedy crooks have been using their money and influence to buy political favours.
That explains why the president went ballistic at the G8 summit in Canada last week when asked about the $3.8bn (£2.5bn) fraud and why at the weekend he was urging that those guilty of corporate crime should do time in jail rather than face financial penalties.
The idea of Bush the regulator seeking to use government intervention to prop up Wall Street is hardly convincing, given his record. It certainly has not impressed the Democrats, who are seizing the moment to press for tougher accounting standards and have promised to hound the Republicans on corporate sleaze until the mid-term elections in November.
Bush's handling of the economy is going to be a big issue, with the ever-present fear for the president that he will end up like his dad, a one-term incumbent of the White House who won a war but lost an election when the economy went sour. The odds on that happening are shorter than they were at the end of last year, because the immediate future is not going to be easy, either for the US or for the global economy.
Stimulation
There is, to be sure, a scenario in which things turn out all right, and where we will eventually look back on the middle of 2002 as a period when the recovery ran up against a few temporary roadblocks before continuing on its merry way. Monetary policy will remain loose, with no risk that the US Federal Reserve will raise interest rates any time soon. Indeed, if the stock market remains wobbly, there is more chance of a cut than an increase.
The stimulation provided by monetary policy, together with the fiscal boost from tax cuts and higher defence spending, should underpin domestic demand - the main engine of growth. Externally, the lack of any policy support for the dollar means that the American currency will continue to weaken, making exporters more profitable and imports more expensive. The long overdue fall in the dollar will allow the rebalancing of the US economy, narrowing the trade deficit and encouraging a rebuilding of personal saving.
Europe will be the mirror image of the US, with the stronger euro allowing the European Central Bank to keep interest rates lower than they would otherwise be. That, coupled with the lower cost of imports, will feed through into higher consumption, and the recovery of domestic demand will free the eurozone from its over-reliance on exports as the mainspring of growth. Europe picks up the slack as the US purges itself of its past excesses. Easy peasy.
The above may come to pass. This may be the one occasion when things go according to the textbook, and there is no doubt that the macroeconomic consequences of WorldCom should be helpful.
It is unlikely that the full impact of the 11 interest rate cuts made in the US last year has yet been felt, but it had been thought until quite recently that Federal Reserve chairman Alan Greenspan would be looking to nudge up the cost of borrowing as insurance against the recovery getting out of hand.
Such thoughts, judging by last week's decision by the Federal Reserve to leave rates on hold, have now been banished. Lessons have been learned from the malign neglect of the Japanese economy in the first half of the 1990s, when the pricking of an asset price bubble was followed by inaction and a steady descent into deflation and slump.
On the other hand, sensible strategists plan for the worst case scenario, and it's not hard to imagine an outcome far nastier than the one outlined above.
Consider the very real possibility that there is a fresh spate of corporate scandals over the coming months. No stone is going to be left unturned as policymakers, the American public and the media seek to make amends for their previous gullibility. The mood in the US is angry; people feel they have been taken for a ride and they want heads to roll.
Corporate chicanery
It beggars belief that the bloodletting will uncover no further cases of corporate chicanery. Even if, miraculously, the rest of Wall Street proves to be squeaky clean, it is clear that there has been a colossal loss of trust in the integrity of the US corporate sector.
So given that for the time being, it will be hard to find anyone who believes that a set of results from an American company that is worth the paper it is written on, what is likely to happen to the stock market and the dollar? You don't need to be George Soros to work out that both will remain under serious downward pressure.
In the circumstances, the corporate sector will no longer feel able to gull in vestors with accounting sleights of hand, and will have to find other ways of restoring profitability.
The squeeze is particularly acute in the new economy, where companies took on far too much debt to finance their lavish expansion plans. Wall Street is awash in corporate junk bonds, and the interest rates on them have been rising sharply.
As developing countries have found to their cost, in troubled times the risk premium on dodgy paper goes up. The corporate spread on junk bonds - the gap between the interest rate on rock-solid treasury bonds and the interest rate paid by companies perceived to be high risk - has been widening. The higher cost of borrowing means that companies can either save money by mothballing expansion plans or cutting jobs, or face the risk of going out of business.
A savage bear market will lead to lower investment and a new round of de-stocking, both of which will limit US growth prospects. The cheaper dollar will make exporters more competitive, but the 10% depreciation of the past couple of months has to be viewed against the 60%-plus appreciation from the mid-1990s onwards. It will take a much bigger devaluation before there is the remotest prospect of the US enjoying export-led growth.
As far as the consumer is concerned, the beneficial impact of lower interest rates will be offset by the risk of unemployment, the higher cost of imports and the negative wealth effect of falling share prices. Real incomes and consumer confidence are likely to suffer, with the only question being the degree to which Americans decide to tighten their belts.
Economic policy will no doubt seek to counteract these forces. It is the intense squeeze on corporate finances, exacerbated by brutal competition, that may persuade the Federal Reserve that rates should be further reduced.
But the problem is that policymakers don't have many shots left in the locker. Bush has already cut taxes once this year, pushing the budget back into deficit, and the Federal Reserve has cut rates to just 1.75%. As a result, it will soon become apparent that the strength of first quarter US growth was an aberration. A sluggish period of growth or a double-dip recession seem far more likely than the sort of sustained, rapid recovery that was being talked about a couple of months ago.
Schadenfreude
After having their noses rubbed in it for so long by the Americans, it would be understandable and forgivable were policymakers in Japan and Europe to indulge in a little schadenfreude at Uncle Sam's misfortune. But the desperate attempts by Tokyo to prevent the yen rising against the dollar tells its own story. Japan and the eurozone would be seriously damaged by a prolonged US downturn, and there are already signs that consumer and business confidence is weakening. Exports into the world's biggest market will be lower, while competition from those Asian countries in which the currency is linked to a falling dollar will be all the stiffer. The sinews of globalisation mean that there will be strong feedback effects from the US to the rest of the world. Latin America, with riots in Argentina last week and growing fears about Brazil, is an accident waiting to happen.
We are now entering the endgame of the crisis that has been rumbling through the global economy for the past five years. WorldCom's collapse does not mean that capitalism is about to self-destruct, nor does it mean that the American economy is finished. It should be remembered that the US was written off in the decade that followed Watergate and the end of the Vietnam war - only to reinvent itself.
One reason both the US and capitalism have shown such powers of recovery is that they have been quick to learn the lessons of policy errors and to take remedial action. The mistake of the past 20 years has been to surrender the economy to the interests of big finance and allow deregulation to turn Wall Street into the modern equivalent of the wild west, with the constraints imposed by Roosevelt dismantled. The more WorldComs and Enrons that come to light, the greater will be the pressure for big finance to be reined in. And quite right, too. It is time for ordinary Americans to win their country back.
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